Citi: A Single Paragraph Explains Why Currency Tensions Will Get Much Worse Next Year

In case you were wondering whether emerging market currencies
would keep appreciating into next year, then look no further than
the paragraph below from Citi. It sums up the key drivers quite
succinctly -- Negative real rates in emerging markets whereby
inflation is higher than interest rates, easy monetary policy in
the U.S., GDP growth differences between emerging markets and
developed ones, etc..

Citi's David
Lubin:

A one-paragraph summary of the EM story right now helps
to explain why fx appreciation, reserves accumulation and capital
controls are the order of the day. Capital flows to EM
are being driven by powerful ‘push’ factors, particularly in the
form of i) negative real interest rates and ii) the expectation
of further increases in US liquidity if the Fed’s balance sheet
undergoes further expansion (our abbreviated history of capital
flows to EM in Figure 1 makes it clear that investor enthusiasm
for EM is generated by low real US rates even during periods of
weak US growth). At the same time, powerful ‘pull’ factors are
drawing capital flows towards EM in the form of a large and
widening differential in GDP growth rates between EM and DM,
alongside a widening interest rate differential (Figure 2).

We admit the chart below isn't exactly sexy, but it shows how the
difference between interest rates in emerging markets vs.
developed ones (The G4), will only expand as we enter the first
half of 2011.

They'll be even more pressure for developing countries to hold
back the torrent of capital with capital controls.

Many countries are struggling against the currency appreciation
that results from these push and pull factors, with the result
that official fx interventions are accelerating, together with a
greater willingness to experiment with controls on capital
inflows. The past month has seen a further rise in Brazil’s IOF
tax to 6%; a decision by Thailand to impose withholding tax on
foreign owners of domestic securities; and plenty of talk that
other countries (Korea, Taiwan, Indonesia and Israel for example)
are considering similar measures. Meanwhile, central bank
purchases of fx remain heavy. In the first 3 weeks of October,
for example, the Brazilian central bank bought over US$4bn; the
Bank of Israel over US$2.5bn; the Bank of Indonesia over US$2bn.